On December 11, 2008, Bernard Lawrence Madoff (born April 29, 1938), chairman of Bernard L. Madoff Investment Securities LLC, was arrested by the FBI. At that moment, he moved from being a hedge fund principal with suspiciously consistent returns, to being a suspect, thought to have bilked investors out of $50 billion. So far, according to the FBI and other sources, this is the largest investment fraud ever committed by a single individual.
People all over the world read the headlines, and knew this guy must have done something bad, but a lot of people don’t know exactly what a hedge fund is, or what Madoff did wrong.
A hedge fund is a private investment company which accepts money from a limited number of investors. The reason it is called a hedge fund is that the strategic intent is to hedge or counter balance the market. In other words, hedge fund managers are hoping to use a strategy which causes their fund to go up when the market goes down. To do this, hedge funds often use investment instruments which are considered higher risk than what you might find in your 401K. These could include puts, calls, option, and exotic options, and derivatives to name a few.
Hedge funds are regulated outside of the scope of “normal” investment companies, such as mutual funds. Their shares are also not readily available to the public. Compared to the scrutiny a mutual fund is subjected to and the disclosure requirements they must meet before selling shares to the public, hedge funds are like the Wild West of the investment world.
Because of the perceived risk involved and the lack of regulation and investor protection, investment in hedge funds is generally only open to “accredited” investors. There are strict rules as to how much the minimum investment must be. Generally the minimums are quite high, often in the millions. Rules also stipulate that the millions you invest in a hedge fund should be no more than a certain percentage of your total net worth or total investable assets. Hedge funds are generally not allowed to advertise and are often limited in the number of investors they are allowed to accept.
The basic idea is that people investing in hedge funds are extremely wealthy. They have experience with investing, and their hedge fund investment is just a piece of their overall investment strategy. These people usually have advisors, such as brokers, planners, accountants and attorneys who should be looking out for their interests. The investors in a particular fund often know each other and know and trust the fund manager. The fund doesn’t advertise, so it acquires new investors simply through word of mouth. Someone invests, makes money, and tells two friends. They tell two friends, and so on.
Hedge funds are in no way illegal or immoral. They serve a purpose which exists outside the scope of the average person’s radar. The investors in hedge funds are often institutional investors, such as endowment funds and retirement and pension plans.
So, what did Madoff do wrong?
It was publicly known that Madoff paid brokers “for order flow.” This means giving a commission directly to a broker for buying shares. The rules on how brokers are compensated; who can pay them, and how much, are very strict. You never want to create a situation where a broker might be tempted to sell an inferior or inappropriate investment to a client, simply because he was to receive a bigger or additional commission.
While hedge funds are subjected to less stringent regulation than mutual funds, they are not completely outside of the law. These funds are required to file certain disclosure documents, showing what they were invested in. But, just before the end of each quarter, when these documents should have been prepared, Madoff’s fund sold out their investment positions. So, no one actually knew where the money was invested.
Another reason outside entities were keeping Madoff in their sites was because of his returns. Over a period of years, Madoff’s investors received a steady 10.5% return on their investment. This number is not so shocking, if we consider that small cap stocks, over a long enough time line, are expected to yield a similar return. What is strange however, is that Madoff’s returns were consistently between 12% and 13%. Normally, we would expect an investment to fluctuate much more widely over a ten year period.
Just to put this in perspective. I checked the ten year average of a technology mutual fund that I sold while I was an investment advisor, working in New York City. From 1998 – 2001 the fund experienced a growth of nearly 300%. If you had invested $10,000 in 1998, your investment would have been worth over $35,000 in 2001. Today it would be worth about $7,500. Checking a small cap mutual fund, which we would expect to be somewhat less volatile than technology, your $10,000 investment in 1998 would have hit a high of about $35,000 in 2007 and would currently be worth about $17,000.
This type of fluctuation is in sharp contrast to Madoff’s two-point swing.
The big crime that Madoff committed was Ponzi.
Ponzi is a name given to an investment scam, first popularized in the USA, in 1903, by Charles Ponzi. The idea is, you get a bunch of investors, and promise them high returns. They all give you an initial investment, let’s say 100,000 each to make the math easy. At the end of the first quarter, you pay them all their quarterly earnings. You send each investor a check for $5,000.
“WOW!”, thinks the investor. I earned $5,000 in one month. That means 5% per month, or 60% per year. This is great. The bank is only paying 2.7% per year. And so, the investor invests more. And he tells his friends to do the same. As long as you keep sending checks to the investors, they will keep investing, or at the very least, not want to take their money out. As long as new investors join, you will have money to continue making payments to the old investors. They think they are earning interest, dividends, or investment returns. But in actuality, all they are getting is their own money back.
For Madoff, the final nail in the coffin came when investors demanded $7 billion of their cash back, and he didn’t have enough left to pay them. Now, he faces up to 20 years in jail. But he will always be remembered as the New King of Ponzi.